Occasional Thoughts and Observations From My Career as a Financial Professional

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A client recently asked me to look at an investment proposal he was considering. He isn’t familiar with real estate deals, so his basic questions were:

Is it a good project?

Is it a good deal?

What are the risk factors?

Please explain the deal structure. Is it a common structure for similar deals?

Here are some thoughts on how to evaluate this sort of a deal:

This Project

In this case the project involved purchasing land in a Southern California town, building a senior living facility, and operating it for a period before selling it. They were looking for a $10 million investment.

Land acquisition, permits and other pre-construction were to take 7 months, construction 12 months and lease-up (the time it takes to lease all units) another 12 months. The proposal was to hold and operate the facility for 10 years, but vaguely suggested the possibility of selling at the end of the lease-up period.

Is This Your Kind of Deal?

This is a passive deal in which the investor has no control over the property or decision process. Are you ok with that? And are you willing to let someone hold your money for 13 years?

This isn’t to suggest that it’s a bad deal. A lot of people have made good money on investments like this. You just have to be sure it fits your needs and expectations.

Who is the Sponsor?

The sponsor is the person or organization that conceived of the project, put together the plan, and is now looking for equity financing. This is a long-term strictly passive investment, so you need to have full confidence in the sponsor. His (or her, or their) experience, reputation and integrity are critical to the project’s outcome. Questions to ask include:

Has the sponsor completed similar projects in the area? This is especially important in Southern California, where local governments can make you jump through hoops before they approve a project.

Does he have experience with land entitlements in the region? How about his experience with the local municipality?

Does he have experience with construction management and budgets? Has he selected reputable engineers and contractors?

What is his expertise in operating senior living facilities, or whatever else the project may involve? Does he have a reputable management company on board?

How much is the sponsor investing? Do you want to be a limited partner when the person controlling the project doesn’t have anything at risk?

If the sponsor has previous successful experience, why isn’t he using previous investors?

Risk Factors

The first big risk has already been discussed. You’re letting somebody control your money for 13 years. First, is the sponsor trustworthy? Next, the longer your money is outside your control, the more chance there is that something will go wrong. That’s a main reason why long term projects need to have a significantly higher return than short term projects.

That whopper of a consideration aside, here are some specifics:

General business risk. Is this the right project in the right place at the right time? The sponsor should have comprehensive, convincing information to help you make this decision. Senior living facilities sound like a pretty good bet these days, but is it the right time and place? Clearly, you should do your own due diligence.

What happens if cash flow projections are bad, or something unexpected happens, and more funding is required? Are you required to invest more? Will you have to give up a big part of your return to attract a new investor who knows you can’t complete the project?

Land entitlements (permits, approvals, etc.) require expertise and knowledge of the local government process, and VERY often take a lot longer than expected, running up costs and dragging down financial returns. The fewer permits required, the more likely the project will move ahead on schedule. That will make the land more expensive, though, because someone else took the entitlement risk.

In my experience, the land development phase almost always goes over budget. Is there enough contingency? Again, the less land development required, the better chance of staying on plan. But it will also make the land more expensive.

Assumptions used in projecting revenues and costs.

Are the unit rental rates in the projections achievable? This particular proposal used a 3% annual increase in rental rates over the entire 10 year operating period. This sounds aggressive to me, but maybe the sponsor has data from other projects to support it.

Expense assumptions need to be examined closely, too. Having done hundreds of budgets and projections in my career, I can promise that expenses are always projected on a “best case” basis.

Are there holes or errors in the cash flow projections? Something I noticed in this specific proposal is that there were no operating costs budgeted for the 12 month lease-up period. I also didn’t see the sponsor’s fees deducted from the cash flow projections.

Is it a Good Project?

Over and above your due diligence regarding the risk factors, attention turns to the financial returns. How you view the proposal is important:

This project is really two separate projects – 1) acquisition, construction and lease-up of a senior living facility, and 2) investment in an operating facility. These are very different projects with very different risks and expected returns, so they need to be analyzed separately.

This proposal did not separate the two phases, but when I applied the sponsor’s valuation assumptions (a 7% cap rate) at the end of the construction and lease-up phase, there was no profit whatsoever, even though this is the phase with the greatest risk. Did the sponsor even bother to check whether he was overpaying for the land? Any suggestion of selling at a profit at that point has flown out the window.

It is common for investment proposals to show project returns on a leveraged basis, maybe even applying tax assumptions that may or may not fit your situation. Not unreasonable, because the project is probably using debt financing, and this would be the actual return on your equity investment.

The problem is that it makes it difficult to compare the quality of this project against other similar projects. The only way to compare one project with another is to take out the variables, and show the pretax unleveraged return. Of course, this proposal did nothing of the kind.

This project seemed to be projecting a 23% annual after-tax return to the investor, but the financial analysis didn’t feel reliable. Anyway, that’s a heck of a return, and you would really want to ask if it’s too good to be true.

The Deal Structure

Once the investment is made, then the deal is all about who takes out cash – when and how much. This deal was fairly typical.

Sponsor fees –

The sponsor typically takes an up-front fee based on funds under management. In this situation, it was 1.0%, probably about enough to recoup the sponsor’s start-up costs.

He also typically also takes a percentage of the selling price when the project is sold, 1.0% in this case. This is his bonus.

The sponsor will also take a fee for the duration of the project, often measured as a percentage of assets. It seems reasonable that the sponsor have some cash flow. In this case it was 2.5%, or $250,000 a year.

The “waterfall” – This is a detailed agreement outlining where and when free cash flow is distributed among the investors and sponsor.

This particular agreement was unclear as to how the monthly cash flow would be distributed, but it would generally be based on a percentage formula, and the investors’ share divided according to their relative investment.

There is often a “preferred return” when the project is sold. That is, the investor gets his entire investment back, plus an amount that brings him up to an agreed rate of return (7.0% in this case) before the sponsor gets to share in the profits.

After the investor gets his preferred return, then the remaining cash flow is shared according to any simple or complicated formula agreed to in the partnership agreement.

The great thing about deals is that they are negotiable, or you can walk away. You don’t have to accept any terms you can’t live with.

Are You Getting a Good Deal?

A good deal is in the eye of the beholder…

Is the projected return better than your other investment opportunities, given the risk factors involved?

Are you getting as good a return as you would on a similar project?

Are you satisfied that the sponsor is being rewarded reasonably?

Are you satisfied that you are getting as good a deal as other investors in the project?

My Recommendation

You’re probably not surprised that I recommended against this particular deal. I did recommend, though, that my client keep an eye out for other deals to educate himself. You never know when the right deal might present itself.

When you sell your business, you want to do everything possible to get the right price. That often means forgetting about how you have run the business, and looking at it from the buyer’s point of view.

What the Buyer is Buying

Generally speaking, a buyer will be willing to pay a price that is a multiple of the company’s annual cash flow. The multiple varies widely depending on the industry, the economy and many other factors. The price the buyer pays, though, will be a multiple of his expected cash flow – not yours.

The harsh fact is that the buyer doesn’t care how you ran the business. Certainly, he will keep what he sees as the best practices and procedures, and will probably keep most of your people, but his ideas on executive compensation, business development, human resources, inventory control, and a host of other subjects will probably differ from yours.

I actually saw a deal fall apart because the seller insisted on dictating how the business would be operated AFTER he was gone.

The trick is to know what the buyer believes he is buying.

Normalizing Results

It’s a useful exercise to adjust historical earnings for unique, unusual or non-recurring items, so future cash flow projections reflect the results the buyer is likely to achieve. This is called “normalizing” cash flow. Depending on how you’ve been operating the business, this process may identify certain assets or liabilities that should be valued separately.

Here are some examples:

Owner’s Compensation

A homebuilder’s owner paid himself a salary that was much higher than the CEO of any similar company would normally receive. It was his decision as to whether he wanted to receive the funds as salary or as a draw against earnings, but it did cause widespread resentment within the company, especially during lean times.

The important point here, though, is that by adding back the excess owner’s compensation into the cash flow projections, the company’s value increased by a multiple of say, 6 or 7 times that amount.

Below-Market Rents

A retailer had been in business for many years, and was such a desirable tenant that it could drive a very hard bargain with landlords. It was common to find 20 year leases at below-market rates, with 10-year extensions. A careful reading of the lease on the ideally-located head office revealed that it ran in perpetuity.

The low rents increased the company’s cash flow, and would have been taken into account if the company had been valued strictly on a multiple of that cash flow. Valuing leases uses much the same arithmetic as arriving at a multiple of earnings, but the terms of these leases were so unusual that we saw the need to evaluate them as a separate asset.

Ultimately, we prepared cash flow projections using much higher market-rate rents. This reduced the amount a buyer would pay for the company based on its projected cash flows, but it was more than made up by the higher value assigned to the leases as a separate asset.

Unusual Expenses

The owner of another company had a unique set of personal beliefs, and insisted that all of his employees and vendors share or participate in them – at considerable cost. Everyone was required to attend expensive week-long seminars by a California-based consultant who taught them how to deal with their personal fears. Another consultant was flown in from San Francisco for a week to realign the chakras of the executive staff. The owner catered lunches several times a week, so the entire staff would attend his meditation sessions. The company sponsored a project in which meditation experts gathered in Sedona to effect world peace.

It was highly unlikely that a buyer would continue these human resource policies, so we added back their cost to normalized cash flow, and substantially increased the asking price of the company.

Historic Land Values

A land developer and homebuilder had been in business for many years, and owned properties it had purchased up to 30 years previously. The profit margins on the houses it sold were significantly higher than they would have been if the land were acquired more recently.

There had been talk within the company of separating the land component of the business from the homebuilding component, in order to clearly see where the profit and returns on investment really came from, but the initiative never got off the ground.

The low historic land values were reflected in profits, but not in the actual operating cash flows, so a valuation based on a multiple of cash flow didn’t make sense. We prepared normalized cash flow projections for the homebuilding business based on market prices for the land, and did a separate valuation of the land reserves, based on those same market prices.

Non-Recurring Costs

Most companies have expenses they needed to incur a single time, or for a limited period. Examples I have seen include legal fees and settlement costs for lawsuits, discretionary bonuses for unusual personal or company performance and employee termination costs. I worked with a company that had incurred huge expenses trying to start a new line of business that was never realized. Another committed to a year-long sponsorship of a local sports team in a marketing effort that was judged a failure.

None of these costs can be expected to be repeated by a buyer of the company, and so should be added back to the normalized historic earnings, and to the cash flow projections used to place a value on the company.

Does your CFO understand the value of normalizing your cash flows from a buyer’s point of view?